Borrowing from your 401(k): The risks

Starting to save for retirement at a young age is one of the smartest steps you can take to ensure your future financial security, so is it worth jeopardizing that security by borrowing from your 401(k)? Many people do … and at a relatively early age.

Here’s a look at the pros and cons of taking out a 401(k) loan in a financial emergency.

Is borrowing from your 401(k) an option?

Employer plan sponsors are not required to allow for 401(k) loans, but roughly half do, according to EBRI. Plan participants can read their 401(k)’s summary plan description (SPD) to find out if they are eligible to take loans from their own plan. If so, the SPD will state the company’s loan terms, which must fall within IRS guidelines. Employees can also check with their human resources department.

The IRS limits how much workers may borrow from their 401(k) plans. Employer plan sponsors cannot allow plan participants to borrow more than: 1) the greater of $10,000 or 50 percent of their vested account balance; or 2) $50,000, whichever is less.

In other words, if your vested 401(k) balance is $60,000, you may be able to borrow up to $30,000. If your vested balance is $120,000, you may be able to borrow up to $50,000.

You must also make substantially equal loan repayments at least once per quarter, and those payments must include both principal and interest. You cannot take more than five years to repay the loan (unless the loan is specifically for the purchase of a primary residence, which allows for a longer payback period).

One of the perks of borrowing from a 401(k) plan, or its nonprofit- and public-sector equivalents, the 403(b) or 457(b) plans, is that unlike commercial loans, they do not require a credit check, so they are available even to those with unfavorable credit scores.

Also, while your goal should be to repay your 401(k) loan in full and on time, if you do default, it will not hurt your credit score.

They are also an available source of liquidity in a pinch, unlike other retirement accounts. Indeed, the IRS does not permit loans from Individual Retirement Accounts (IRA)s. Any distribution from an IRA before age 59-1/2 is subject to ordinary income taxes, plus a 10 percent early withdrawal penalty.

When a 401(k) loan may make sense

About one-fifth of all 401(k) plan participants who had the option to borrow from their plans had a 401(k) loan outstanding at the end of 2014, according to the EBRI report. Their average loan balance was $7,780 and the median loan balance was $4,239.

Most financial professionals, however, insist that those saving for their retirement only tap their 401(k) as a last resort.

“The reason is that this money is specifically for use when you are not working,” said IRS enrolled agent and chartered retirement planning counselor Abby Eisenkraft, CEO of Choice Tax Solutions in New York City. “If you are young, working and can't save, what happens when you are older and not working? Social security hardly covers rent for most people, and for others with a paid up mortgage, there are still real estate taxes and other large expenses.”

Another problem has to do with taxes.

Because participants contribute pretax dollars to a 401(k) plan, but repay a 401(k) loan with after-tax dollars and also pay taxes when they take distributions from the plan, participants essentially pay taxes twice on the loan amount, said Pamela Bobersky, a qualified 401(k) administrator and president of AMI Benefit Plan Administrators in Youngstown, Ohio. Further, many plans charge a fee to take out the loan and a fee to maintain the loan.

Make sure you are borrowing because of a true emergency, such as not being able to pay your rent and not being able to downsize to a less expensive residence.

Yes, people do borrow from their retirement savings to buy a home, to finance an education, to start a business or to take a vacation. But these aren’t always good reasons to borrow from a 401(k). And in some cases there may be better ways to borrow — better because they’re less expensive or because they’re less likely to impact your retirement. In other cases, borrowing means you’re living beyond your means and should try to solve that problem without taking out any kind of loan. (Calculator:How much should I save for retirement?)

That said, if you have no way to cut your expenses, a 401(k) loan might make sense. Further, if you have bad credit and can’t get a commercial loan at a low interest rate, a 401(k) loan may be your best option.

But the math has to make sense for your individual situation. If you’d lose 6 percent per year in investment earnings by borrowing from your 401(k) but you’d avoid paying 20 percent interest on a personal loan or credit card balance, the 401(k) loan will be less expensive. What’s more, if the interest you pay on your 401(k) loan is equal to or greater than the investment earnings you miss out on by taking a 401(k) loan, the loan will not hurt you in the long run.

What you could lose when you borrow from your 401(k)

Don’t take a 401(k) loan if you don’t have the discipline and the financial means to repay it.

Eisenkraft said that the same behavior that got a person into trouble in the first place will often continue unless they make a conscious effort to change.

But Bobersky said repaying the loan is not normally a problem because many plans require loan repayment through payroll deductions. “The issue is that many participants decrease their contribution amounts to the plan during the time of repayment, making it harder to reach their retirement goals,” she said.

Indeed, a 2015 study from Fidelity found that about a quarter of participants who borrow from their 401(k)s make lower contributions or no contributions after taking out a loan. This finding makes sense, since people who take out 401(k) loans are struggling financially and repaying a loan leaves fewer resources to contribute to retirement.

Failing to contribute to your 401(k) for any period of time is a missed opportunity that you’ll never get back, though. And if your company matches a percentage of retirement contributions, there’s the added problem of leaving money on the table. So if at all possible, and if you plan allows it, keep making contributions to your retirement savings account at the same rate while you’re repaying your loan.

But at the very least make sure to repay your loan. Why? Failure to repay your loan balance on time will be considered a distribution and you will owe taxes (at your marginal income tax rate) and a 10 percent early withdrawal penalty if you are younger than age 59-1/2 on the amount you have not paid back.

While you’ll have to pay taxes on any 401(k) withdrawal eventually, even if you wait until retirement age, the penalties are a waste of money. Further, never paying yourself back could significantly hurt your long-term net worth. The money you take out won’t be earning investment returns and compounding. Agreeing to repay your loan through automatic payroll deductions can help keep you honest.

Also avoid taking out a 401(k) plan loan if a layoff, job change, or company acquisition seems imminent, because any of these events could mean that you would have as little as 60 days to repay your loan in full — an obligation you might not be in a position to fulfill, turning the unpaid loan balance into a distribution.

Another potential problem with 401(k) borrowing arises if you must sell investments at a loss to borrow money. It is one thing to lose money on paper when the stock market is down; it’s another to make those losses real by selling your investments.

Hardship withdrawals

Those experiencing a true financial crisis may also be eligible for a hardship withdrawal from their 401(k), 403(b) or 457(b) plan.

As with loans, your plan sponsor is not required to offer hardship withdrawals and it is up to them to determine which conditions apply.

Under Internal Revenue Service guidelines, the employee, the employee’s spouse or the employee’s dependent must have an “immediate and heavy financial need” and the amount withdrawn must be “necessary to satisfy the financial need.”3

Acceptable reasons to take a hardship withdrawal may include paying medical expenses, buying a primary residence, paying tuition and fees, avoiding eviction or foreclosure from a primary residence, paying for burial or funeral expenses, or repairing a damaged primary residence.

You cannot take a hardship withdrawal from retirement savings if you have other resources to meet your need, according to the IRS.

For example, someone who owned a vacation home, but was having trouble making payments on their primary residence, would probably be expected under the terms for most 401(k) plans to sell the vacation home to meet cash flow problems rather than take a hardship withdrawal.

Most 401(k) plans also provide that hardship withdrawals also are not available if you could obtain a commercial loan to solve your problem or if you have not exhausted your options for taking out a loan from your plan.

If you take a hardship withdrawal, you will not be allowed to contribute to your plan again for at least six months. The distribution from the savings plan will be taxed as income and assessed a 10 percent penalty unless you are at least 59-1/2 years old.

Unlike a 401(k) loan, a 401(k) hardship withdrawal does not have to be repaid — in fact, you cannot repay it even if you want to.

At most, you could try to make up for the withdrawal by increasing your 401(k) contributions for retirement later on when your financial situation improves.

For example, if you were contributing 5 percent of your pretax earnings to your 401(k) before you took the hardship withdrawal, once you’re allowed to contribute to your plan again and have the resources to do so, you could increase your contribution rate to 10 percent or more.

401(k) plans should not be used as a piggy bank. But for those experiencing a financial emergency, a loan or withdrawal from savings does not necessarily doom their financial future, either.

Just be sure you understand the consequences and consider all alternatives first.

The information provided is not written or intended as specific tax or legal advice. MassMutual, its employees and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel. Opinions expressed by those interviewed are their own, and do not necessarily represent the views of Massachusetts Mutual Life Insurance Company.